Whether you’re investing in real estate or dabbling in trading on the stock market, it’s important to always keep the IRS in mind. Especially when it comes to these types of assets, known as capital assets, there are taxes lurking around the corner for the unsuspecting individual.
Be prepared with the right knowledge so that taxes don’t hit you unawares. Educated investors are in the best position to minimize their taxes just by learning a few of the basics.
What are Capital Gains?
The IRS separates taxable income into two categories: ordinary income and capital gains. Ordinary income is based on earnings such as those received from employment, interest, dividends, or property. Hence, ordinary income tax rates vary depending on how much taxable income you actually bring in and can vary from 10% to 37%.
Capital gains are the profits made by selling capital assets, such as real estate, stocks, bonds, or precious metals. Even collectibles like coins, antiques, or jewelry can be considered a capital asset. The government issues a tax on these profits, hence, the capital gains tax.
Gains are calculated by the total sale price minus the original purchasing cost. If there is any profit, or gain, then taxes are due when the asset is sold.
Not every sale will result in profit, however. Capital loss is when an asset sells for lower than the original price, and these losses can be used to offset long-term capital gains on your tax return, which then lowers how much you pay. Capital losses cannot be used to reduce your ordinary income tax.
Short-Term and Long-Term Capital Gains
When we talk about capital gains tax, that refers to the tax on long-term capital gains. When it comes to short-term capital gains, the sale of these assets are taxed like ordinary income. Short-term capital gains come from assets typically held for one year or less. They are taxed like ordinary income to discourage short-term trading.
Long-term capital gains are those assets owned for more than one year. They are taxed at a lower, preferential rate compared to short-term capital gains. The tax rate depends largely on your income tax bracket, so people with a taxable income of less than $80,000 for those filing jointly or $40,000 for those filing separately will pay little to no capital gains tax.
Married couples filing jointly with an income from $80,001 to $496,600 and individuals with an income of $40,001 to $441,450 pay a 15% tax on long-term capital gains. Couples who earn $496,601 or higher and individuals who earn $441,451 or higher pay a 20% capital gains tax.
When it comes to losses, they are first used to offset gains of the same type. Short-term losses offset short-term gains, and the same goes for long-term losses and long-term gains. Only then can net losses be used to write off the other type of gain.
Capital Gains on Your Mutual Funds
When it comes to mutual funds, capital gains work differently. Capital gains distributions are payments received from a mutual fund, giving you a portion of the proceeds from the fund’s sales of assets. The law requires mutual funds to make regular distributions to their shareholders. You can either take that distribution as an immediate payment or reinvest it back into the fund.
It’s important to note that these distributions are taxable to the shareholders either as short-term or long-term capital gains. If you have owned the mutual fund less than a year, you will owe tax on short-term gains. If you have owned it longer, you can record that income as a long-term capital gain.
There are exceptions, such as if the fund is owned in a tax-deferred retirement account like an IRA or 401(k). In cases like these, you won’t receive any distributions or pay any taxes until you start withdrawing from the account. At that point, the distributions count as regular income.
Mutual funds will notify you in advance of a distribution, giving you time to decide to hold or sell. There are several factors to consider at this point, including the age of the fund and the size of the distribution.
If you have only held the fund for less than a year, you will pay taxes at the ordinary income level when you sell, up to 37%. This may prove more costly than simply accepting the distribution gains and taxes.
However, if the fund is over a year old and the distribution is going to be large, it may prove wiser to sell the fund. Selling will be taxed as a long-term capital gain with a rate from 0% to 20% and you won’t be hit with additional taxes from the distribution.
Get Help Understanding Capital Gains Tax
A skilled financial advisor can help you navigate the ever-changing tax brackets and help you strategize your capital gains either through capital losses, tax-advantaged retirement plans, or more. You save much more at tax time if you plan in advance. Contact us to reach an experienced financial advisor.